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Portfolio Rebalancing

Portfolios are rebalanced all the time. Many firms even have the neat ability to automatically re-balance portfolios for you. Along with diversification, people preach automatic re-balancing as a way to protect yourself. I can tell you that it is 100% true. It can and will protect you from earning higher returns in the stock market.

It sounds good on paper. 20% bonds, 60% stocks, 20% commodities/alternative investments. Or if you would like to make it even more detailed:

15% investment grade bonds, 5% high yield bonds, 20% small cap growth stocks, 20% consumer goods and 20% industrial/cyclical stocks combined with 10% in REITs and 10% in a hedge fund.

Keep your investments spread out, and automatically re-balancing your portfolio will ensure your percentages stay spot on and correctly diversified right?

So the only slight issue is that you are ruining your returns. We can just apply a bit of common sense and we will realize the issues with blind/automatic/frequent re-balancing. We will not even need a chart or graph or table this time. Think about what happens when you re-balance a portfolio.

Say you have a portfolio of 10 investments, each one with 10%.

In our first scenario, 5 of them go up 50%, 5 of them stay flat. You re-balance all of them so that they stay at 10% each. What you have just done is, take money out of an investment going up and reinvesting that money in a company that is going nowhere.

Scenario 2, 5 of them go down and 5 of them are flat. You re-balance and dump more money into investments that are going down and taking it out of investments that are holding their value.

For scenario 3, worst case, 5 of them go up and 5 of them go down. So you are taking money out of investments earning you a good return and dumping them into investments that are losing you money.

Not to mention, each time the portfolio is rebalanced, transaction fees may and probably will apply.

What would make more sense when selling and buying another investment, is if an investment has

  • reached it's estimated intrinsic value
  • become impaired, either bad capital allocation, change of management, poor corporate governance, etc...
  • lower potential return than another investment that has become known and actionable

This way, you are selectively selling investments that no longer have the potential for good returns and allocating the money to investments that will offer the ability to provide greater returns.

Most brokerages I have dealt with love automatic re-balancing and asset allocation. Especially if it is done monthly. With transaction fees on each buy and sell, having that done to every single client account for every single holding to make minor adjustments of 1-2% and then doing it 12 times a year? Brokerages would love you for it. While most only re-balance once a year, please keep in mind that automatic re-balancing may not be the best method for you.

One caveat is that it may work in some indexing situations, but when buying and selling individual investments, it can lead to mediocre and depressed returns. More often than not you may be better off just leaving the investments alone.

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